There hasn’t been a better time to buy real estate investment trusts (REITs) since July 2009. That was the last time this “simple signal” flashed B-U-Y.

Investors who bought on this signal then have enjoyed 281.5% returns (including dividends) since. And those gains didn’t require any fancy stock picking – just a one-click purchase of the Vanguard REIT ETF (VNQ).

The signal? VNQ itself paying over 4.3%:

Highest REIT Yields Since the Financial Crisis

But not all REITs are equally successful landlords. That’s especially true today, with entire business models becoming obsolete before our very eyes (such as retail).

We need to avoid VNQ’s landmines in favor of recession-proof REITs. And my favorite names actually pay 7% to 8% or better today, with price upside to boot – we’ll discuss these firms in a minute.

Most income hounds get it wrong. They pile into REITs when their yields are low because they are desperate for any positive income stream. That’s a bad idea because there are only two ways REITs can pay you:

With today’s dividend, and

With tomorrow’s (hopefully higher) payout.

As with stocks in general, it’s usually a bad move to accept a lower-than-usual dividend today in hopes of future growth. That’s a sure way to guarantee underperformance.

A better strategy is buying stocks – especially REITs – when their yields are higher than usual. Over VNQ’s 11-year history, its price has tended to mirror its yield:

Sure, in the short run, the “rates up, REITs down” theory puts on quite the show. When the 10-Year Treasury’s yield rises, REITs usually fall. And when its yield drops, REITs usually rally. This inverse relationship tends to hold up over multiple days, weeks and even months:

A Short-Run Seesaw Between REITs and T-Bill Yields

The theory backing up this price action says that, because REITs borrow money to grow their property empires, they need cheap cash. Yet this isn’t a “must have” criterion for all such landlords. If their costs increase, they can simply raise the rents when the lease is up for renewal, passing on their higher borrowing costs to tenants.

For example, let’s look at a three-year period starting in May 2003 when the 10-year rate climbed two full basis points – from 3.2% to 5.2%. Based on recent REIT price action, you’d expect most firms would be out of business!

But blue chips such as mall operator Simon Property Group (SPG) and self-storage stalwart Public Storage (PSA) not only survived the rate increases – they thrived:

The Best REITs Climbed With Rates

Why? Because rising rates signaled a booming economy – one in which these firms had no problem raising their rents. Both boosted dividends while investors in each stock enjoyed 129% total returns over the three-year period!

Which REITs Will Thrive

In This Rate Hike Cycle?

Firms having no problem issuing rent increases today are easy to spot. They report higher and higher funds from operations (FFO) year after year, which finds its way back to shareholders in the form of an ever-rising dividend.

But you can’t buy just any REIT – or any index or fund. Take VNQ – it has a huge landmine in its portfolio. See if you can spot it:

Why You Shouldn’t Buy VNQ Itself

The biggest problem is in the second line from the bottom: 18.9% of VNQ’s holdings are retail REITs—its largest allocation, and the worst REITs you could own right now.

That 18.9% is sitting right in the path of Amazon.com (AMZN), which is eating big retailers like Macy’s (M), L Brands (LB) and Guess (GES) alive! If these chains are in permanent trouble (which they are), that’s a big problem for their landlords.

Let’s review the rest of the retail landscape from the landlord’s standpoint. And while we’re at it, let’s spin around the REIT world to look at disruption elsewhere. On the whole, REITs are indeed as cheap as they’ve been since 2009. In some cases, it’s for good reason – in others, it’s an opportunity to go shopping.

Stay Away: Retail REITs

As an investment, I don’t like retail REITs. At all.

2017 was one of the worst years ever for retail store closures, easily smashing 2008’s record of 6,163 store closings. Here are some of last year’s members who joined the dubious triple-digit (100+) closure club:

Teavana (379 closed stores)

J.C. Penney (138)

Gymboree (350)

Ascena (268)

Michael Kors (100)

Payless (512)

Bebe (180)

Rue21 (400)

RadioShack (1000)

As these tenants turn out the lights for the last time, do you envy any of their landlords?

I don’t!

Beyond a short-term trade, I’m not sure any retail REITs – no matter how cheap – truly belong in a “no withdrawal” retirement portfolio (where you live off dividend alone and never sell any stock to to fund your personal income needs).

After all, the entire point of living off dividends is to take the stress out of stock market investing. And these firms will be scrambling as long as the internet continues to eat their tenants alive.

With delivery services just beginning to take off, I’m not even sure supermarkets are safe. There are countless Uber and Lyft drivers cruising this country looking for someone, or something, to drive from here to there.

Buy Smartly: Lodging REITs

Hotel landlords have nice business models. They own the facility, but let someone do the heavy lifting of actually running it.

Lodging REITs are quite cheap today, for two reasons:

Lodging is historically cyclical (which means it suffers during recessions), and

Some first-level investors fear competition for hotels from home rental services like Airbnb.

Macroeconomics aside, the reason you shouldn’t fear the first concern is that lodging REITs are already priced for a recession. Many trade for less than 10-times FFO (funds from operations) – which is like a stock trading for less than 10-times earnings or cash flows. Cheap.

The Airbnb-threat can be avoided with careful stock picking. For example, my favorite lodging REIT has hotels out in the suburbs or near airports. These locations are well insulated from the Airbnbs of the world, which are more popular near city centers and resort areas.

There isn’t much competition from vacation rentals for a Residence Inn next to a business park, and business travelers want convenience and a dependable brand. Yet investors incorrectly perceive a competitive threat, putting all stocks in the sector on sale. There’s value (and high, secure income) in lodging if you choose carefully.

Stay Away: Self-Storage REITs

For two decades, self-storage was the place to be for big, steady gains. These stocks delivered 18% annual gains with the least amount of volatility (or price gyrations) in the REIT world:

Self-Storage Was the Place to Be for 20 Years

But today, competition has matured to the point where some self-storage markets are starting to become saturated. This means we must look beyond the blue chips of the space like Public Storage (PSA) and Extra Space Storage (EXR), because these guys are so big they must own space in every market – saturated or not.

Buy Smartly: Healthcare REITs

Healthcare landlords are riding a demographic bull market. According to social security eligibility, 3.6 million baby boomers are now reaching full retirement age every single year. That’s 10,000 boomers every day, or 416 every hour… or one every 9 seconds.

And this trend will continue every single day for the next 15 years.

The Bull Market in 65+ Healthcare Will Continue for Decades

Older adults spend 5-times as much on healthcare as other adults. They visit physicians offices 2.5-times more than other adults.

With these trends in place, you might think every healthcare REIT would be incredibly expensive right now. But some are actually dirt cheap – thanks to Medicare and Medicaid worries.

These programs are the stable payer sources for the majority of patients in healthcare facilities. They’re run by the government, so there’s always something to worry about. And right now is no different.

Skilled nursing facilities (SNFs) seem particularly unloved. SNFs provide the highest level of care an older adult can receive while still living independently. Residents generally get their own room, their own bed, and a private bathroom. Many folks are able to ride out their remaining years here in relative comfort.

While demand for SNFs is heading steadily up, supply—surprisingly—is constrained. Many states limit new nursing home construction. As a result, there are now fewer U.S. SNFs than there were ten years ago!

Supply of Skilled Nursing Facilities is Decreasing!

As investors fret about lengths of stays at SNFs potentially declining due to new payment models, they’re missing the bigger picture. Total patient days are still increasing, and are projected to accelerate higher in the coming years:

Hospital landlords are also selling off with every news leak from Washington, D.C. This doesn’t make much sense, as places don’t come more recession-proof and payer-proof than hospitals.

Buy Smartly: Industrial REITs

In the industrial REIT space, fundamentals vary greatly by, well, industry. I’m most bullish on distribution centers and warehouses thanks to the boom in internet shopping and e-commerce.

In fact, while the Great Recession flattened many business models, warehouse demand has enjoyed a non-stop boom since 2000 thanks to online shopping:

E-Commerce Sales Booming in America

Think about it – more packages are being delivered to your house today than ever before. Each package starts in a warehouse somewhere.

Now that we’ve identified our most promising properties:

Healthcare facilities,

Hotels catering to business travelers, and

Warehouses filled with Amazon.com packages.

It’s time for us to find the best bargains in the sector. And we’re going to focus solely on 7% to 8% yields and higher, because these are meaningful dividends that we can actually use to fund our retirement income needs (without ever having to sell any shares).

You’ll find that, when we buy right, we can actually enjoy 25% to 100%+ price upside on the shares that we hold to boot.

How to Find Bargain REITs with

7%+ Yields for 2018

Now let’s talk about how to value REITs. Let’s start with FFO, because it’s what drives REIT returns.

Funds from operations (FFO) represents the amount of cash a REIT actually generates from its operations. It’s where our dividend originates – which makes it the building block for everything else in the REIT world.

To calculate FFO, we start with net income. Then we add back depreciation and amortization (which are accounting expenses) and subtract profits from property sales (which are one-time events).

FFO Drives Dividend Growth

FFO is the driver of dividend growth for REITs. Figure out where FFO is going, and you know where the payouts are heading – and how fast.

If FFO is stagnant, a firm can only increase its payout by increasing its payout ratio. And this isn’t sustainable over time.

Rising FFO on a per share basis, on the other hand, will basically force management to raise its dividend. And that’s what ultimately drives the stock price higher, because dividend growth is all that matters for REITs. Figure out where the dividend is going, and you know where the stock price is heading.

Reason Being, Yields are

Consistent Over Time

REIT yields tend to be quite steady over time. For example, blue chip self-storage name Public Storage (PSA) usually pays somewhere between 2.5% and 3.5% (absent a financial crisis):

PSA Pays the Same, More or Less

But be careful – just because the current yield goes nowhere doesn’t mean the stock price goes nowhere. In fact, it’s quite the opposite.

Over the last ten years, PSA has increased its dividend by an impressive 264%. Its stock has followed suit, delivering 323% total returns to shareholders!

PSA’s Dividend Drives its Stock Higher

Former dividend grower HCP (HCP), on the other hand, shows that over the long haul the stock price is attracted to the payout curve like a magnet. Its share price (blue line below) might run higher for awhile, but they always found their way back to their dividend (orange line) – for better or for worse.

In 2016, the “worse” scenario happened – HCP chopped its payout by 36% and its share price dove:

Dividend Down, Stock Down

Meanwhile industrial landlord Prologis (PLD) pays about the same dividend it did a decade ago. Its share price has also tracked its dividend – perfectly sideways:

Dividend Sideways, Stock Sideways

REITs can be excellent yield vehicles. But why not buy them for growth too? It is possible to have your dividend and enjoy price upside to boot – and it all starts with rising FFO.

My two favorite REITs today are comfortably positioned in recession-proof industries. They’ll have no problem continuing to raise their rents – and reward their shareholders – no matter what the Fed decides at its next meeting, what Trump tweets or when the stock market finally takes a breather.

2 Recession-Proof Dividend Growth REITs:

8.4% Average Yields and 25% Upside

One of my top REIT buys right now recently raised its dividend again by 4% over last quarter’s payout. This marks the 22nd consecutive quarterly dividend hike for the firm:

It pays a 9.7% yield today – but that’s actually an 10.1% forward yield when you consider we’re going to see four more dividend increases over the next year. And the stock is trading for 8-times funds from operations (FFO). Pretty cheap.

However I expect its valuation and stock price will rise by 25% over the next 12 months as more money comes stampeding into its REIT sector – which makes right now the best time to buy and secure a 10.1% forward yield.

Same for another REIT favorite of mine, a 7.2% payer backed by an unstoppable demographic trend that will deliver growing dividends for the next 30 years.

Its founder Ed Aldag admitted that, fourteen years ago, he had “zero assets, a dream, and a business plan.”

Well his dream and plan were plenty – Ed parlayed them into $6.7 billion in assets!

Ed’s investors have enjoyed 68% total returns over the last five years (with much of that coming back as cash dividends.) And right now is actually a better time than ever to “bet on Ed” because his growing base of assets is generating higher and higher cash flows, powering an accelerating dividend:

I love dividend increases because they are proof that management is actually making more money, so can afford to pay us shareholders more. And an accelerating payout is a flat out cry for help!

Any management team that raises its dividend faster and faster is clearly making more money than it knows what to do with. This usually happens when it achieves a tipping point where its machine no longer requires as much reinvestment to continue growing. So leadership says: “Please, take a bigger raise, shareholders.”

Meanwhile investors and money managers who spot dividend accelerators lose their minds because, in theory, there is no valuation too high for a company that is increasing its dividend at an accelerating rate. Their spreadsheets literally break, and they buy the stock in a frenzy.

Ed’s stock should be owned by any serious dividend investor for three simple reasons:

It’s recession-proof

It yields a fat (and secure) 7.2%.

Its dividend increases are actually accelerating.

These two REITs are both “best buys” in my 8% No Withdrawal Portfolio – an 8% dividend paying portfolio that lets retirees live on secure payouts alone. And they can even enjoy price upside to boot, thanks to the bargain prices they’re buying at.

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As I said from the beginning, this is the best opportunity since 2009 to buy REITs at a discount and live off their dividends. But it’s important to choose wisely. Retail REITs are dangerous, while other recession-proof issues are bargains.

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Chief Investment Strategist

The Contrarian Income Report

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